Inflation-linked debate: The upside of rising prices


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Inflation, far from being a thing of the past, is back in the forefront of investors’ and issuers’ minds. The increased use of innovations such as liability-driven investment means a rise in demand for inflation-linked products. How are the markets responding?

Delegate biographies: Learn more about the panelists

Executive summary

• The inflation-linked market is growing in size and importance

• Reports of the death of inflation have been exaggerated
• New markets are opening up
• As in other markets, the credit crunch has had an impact

PW, Western Asset There is about $1.3 trillion of bonds in the inflation-linked markets, so it’s very important. As inflation caused uncertainty and concern, 2007 was important for the inflation-linked market. US TIPS performed very strongly. What happened there?

DD, Axa This time last year there was a feeling that perhaps inflation was dead but since then we’ve seen a turnaround. The first half of the year saw increases in food, fuel and energy prices. Then the credit crisis came through in the second half and the central banks’ response has led to fears that they are going soft on inflation. Will the slowdown in the economy lead to a fall in inflation or will the policy easing from the Federal Reserve lead to an increase? We’ve got a genuine debate, which can only be good for inflation-linked markets.

JG, Standard Life The dichotomy is the difference between genuine inflation expectations, and inflation expectation as expressed by break-even in the market. Despite the inflation pick-up over the past year, TIPS break-evens have barely rallied. There’s every reason to believe that the Fed will continue to cut rates aggressively. Yield curves have steepened, but break-evens haven’t adjusted. It’s a mystery but potentially it’s also a huge opportunity.

CA, RBS The break-evens are trading in a way that doesn’t support the data, other than at the short end where the shorter-dated TIPS follow the pattern of oil price news. All year, we’ve viewed longer-dated break-evens as an opportunity, not always with success. Having said that, we still consider TIPS to be attractive.

MR, Dresdner Kleinwort Most people believe oil prices are high but might come down sharply. That’s why only the short term of the break-even curve went up, whereas the medium and long part haven’t moved much. Year-on-year inflation will slow down during the course of the year, so that could be why they haven’t rallied.

GFP, Eurizon Capital The oil price increase pushed innovators to develop new alternative energy technologies and such a phenomenon is one more factor that allows people to believe that in the long run we shouldn’t have a structural shift in inflation.

JG, Standard Life
This move in energy prices is different from previous rallies because it’s not just the front contracts. It’s happening across all contracts. There is a perception that this is a longer-term squeeze on energy prices, which will be longer-term inflationary. It’s not a return to the bad old days, but risk has gone up.

PW, Western Asset Break-evens include a risk premium that we can’t measure. But we can guess, so we know that the majority of break-even is the market’s expectations for inflation. It’s supposed to give us the signal that inflation’s under control and policy-makers are doing a good job. The US performed well because interest rates were either held stationary or cut aggressively, or were expected to be cut. In Europe, interest rates rose and there is a more pragmatic attitude from the European Central Bank. Consequently, European markets did poorly. Do you think that’s a signal that inflation expectations in the bond market and the TIPS market are not representative of true inflation expectations in the community?

GFP, Eurizon Capital There could be some demand and supply imbalances in the market that can render the signal less representative of the actual inflation expectations. That is quite evident in the UK, where the hedging needs of inflation-linked liability accounts generate an excess of inflation demand. Maybe we could make a cross-sectional check on a sample of different countries in order to measure the bias generated by such hedging needs. There should be a relationship. Furthermore, because of the still relatively underdeveloped inflation asset swap market, especially in local inflation indices, with low levels of basis trading activity, you can have another source of bias.

PW, Western Asset Were you surprised by the UK inflation market?

DD, Axa
In theory, the UK should be the easiest market to forecast, because of the Bank of England’s explicit inflation target. But the UK illustrates that there can be different supply and demand factors affecting the nominal and the inflation market. They can each be traded independently, and that will affect the level of break-even rates. There was more demand in the UK last year for short-dated conventional bonds, and that has distorted the break-even rates at the shorter end as in previous years liability driven investment purchases have boosted break-even rates at the longer end.

PW, Western Asset Perhaps those following the UK wouldn’t have been surprised by it being so strong, and in a period where inflation was high. What about other markets?

Sweden is coming to the fore. People are starting to consider derivatives and the government is reining in issuance, in nominal and index-linked. At its peak, the 30-year Sweden swap was 35 basis points over the 30-year euro equivalent swap. We’ve had a couple of strong prints in Sweden, but if you look historically at where it has printed relative to the euro, there are not many examples of Sweden being through Europe, yet their swap’s up at 35bp. If the market developed you’d see that moving further still.

PW, Western Asset So could Sweden be one of the star performers?

Activity has increased. But they’re still small markets. The development of lesser non-core indices was one of the themes of last year. But sterling supply and demand was interesting. Towards the end of 2006 there was a lot of corporate issuance and negative basis trading providing swap supply. For the first time since 2000 we saw long-dated inflation swaps trading through bond break-evens. That sustained itself for the first quarter of 2007, following pre-emptive over-issuance in 2006 while conditions were so favourable. When that pressure was taken off, not only did the bond swap go back to being with swaps in excess of bond break-evens, but we’d spent three years with the benchmark 30-year inflation swap stuck in the 300 to 320 range. Once we got through that, 350 was the next stop.

GFP, Eurizon Capital We should remember that in the swap market you suffer from the fact that the sourcing of inflation is indirect, not direct, and that such OTC contracts could generate liquidity and counterparty risks, which can militate heavily against you as a buyer.

Clear statement

PW, Western Asset There were plenty of opportunities for issuers last year. There were also periods where the opportunities were treacherous. In the UK, how did you see the development of corporate issuance, and how did market behaviour frame your approach?

FM, Network Rail
The launch of Network Rail’s gilt surrogate inflation-linked programme was the key development for us last year. For us, it was not just about rebalancing our book to include a greater proportion of inflation-linked issuance; it was a clear statement to the markets about how far we had progressed as a company since we took over operation of the British railways five years ago.

We started five years ago as a new kid on the block, on probation, so to speak, with our regulator, with the government and indeed with the markets. In those five years, operational and financial performance has been transformed. Costs are down, efficiencies are up and performance is up. As a result, we have been able to look beyond shorter-term conventional issuance towards longer-term index-linked, inflation-linked issuance.

But we were faced with a conundrum. With total borrowings of almost £20 billion, we would need to issue in very large size to make any impact on our book. Yet when we first dipped our toe into the inflation-linked market in 2004, we had found it hard to get away an issue of £250 million. We came to the conclusion, somewhat counter-intuitively, that it might be easier to issue in billions than in millions, because the market was lacking a sustained programme of issuance outside of gilts. If we could provide size and dependability through regular issuance, it would not only be worth the while of investors to do the limited credit work you need to look at a UK government guarantee, but also provide confidence to the investment banks that they could provide liquidity. So we were able to create a virtuous circle and, as a result, had a very successful year, issuing three large benchmarks and a number of smaller private placements.

Looking at the wider market, there was much less public finance initiative issuance last year but I don’t think this was particularly because PFIs are looking for other ways of sourcing. It was more about the scarcity of large deals coming to market. As for the utilities, they had a strong first half, but didn’t issue in the second half. The credit crunch is only part of the story. The utilities have done as much issuance as they’re able to do for the time being, and one will see less issuance in the near term.

PW, Western Asset What was going on in Europe?

MC, Italian Treasury
In January we launched the five-year inflation-linked treasury bond (BTP) via direct auction for the first time. We usually launch a new bond through syndication but for the five-year maturity we considered the market completely mature. We kept the size down to €3 billion, but the following month we increased the size as a benchmark. There was also strong demand for the long term, and we made three private placements of 50 years or more but we are not convinced that for such long maturities there is space for launching a benchmark. In June, we launched a new 15-year bond. We issued €4 billion and we reopened this at auction. Now we have a complete curve with bonds of 5-, 10-, 15- and 30-year maturity. For the 10-year and the 30-year we offer tranches via auction regularly during the year. With the 30-year maturity, the interest seems to come more from swap than from real money investors. The challenge for 2008 will be to discover where the demand lies.

GFP, Eurizon Capital Last year there was a pension reform in Italy, with the liberalization of annual TFR (severance indemnity) flows. The workers had the possibility of deciding whether or not to put this money in the second or third pillars vehicles promoted by corporation/worker associations and financial institutions respectively. TFR flows amount to around €20 billion a year. At the end, only 23% of workers adhere to the second pillar, most of them leaving the TFR with their companies, another failure to create efficient retirement saving management. This is the result of a lack of proper fiscal incentives (confirming the problems that come from the huge Italian public debt) and communication, plus the interest of the corporate sector in continuing to benefit from such a convenient source of funding.

MC, Italian Treasury That’s understandable considering that if you leave the money in the public fund, you are assured of a good remuneration in real terms, and the alternative is not well defined.

GFP, Eurizon Capital
We should clarify that by pointing out that the TFR left to the company grows at 1.5% plus 75% of the Italian CPI inflation. So one can say, with high probability, that such remuneration is lower than the one offered by investment plans properly designed and managed for medium-term/long-term investment horizons. Then you have corporate risk. So the pension industry in Italy missed the opportunity to develop this virtuous circle where you have good managers attracted by good assets under management. The real losers, at the end, are the workers and the future retirement consumption. Furthermore, that could have been the catalyst to develop a strong demand for Italian inflation-linked products, and eventually also for wider European ones. So we missed an opportunity to move Italian retirement-saving behaviour closer to Anglo-Saxon best practice.

Talking about other sources of natural inflation hedging demand, in Italy we have only about €15 billion in defined benefit plans and only a few do some liability-driven investment, but not with the asset-liability management practice and regulatory requirement of the Anglo-Saxon world. Furthermore, the insurance industry issues mainly minimum guaranteed with-bonus policies not linked to inflation. Finally, some endowments are liability-linked to Italian inflation and others tend to beat the nominal growth rate of Italian GDP, but they are not very aware of the liability side.

Italian workers are comfortable with the TFR rule, so retail or pension fund products linked to Italian CPI will develop, but slowly.

PW, Western Asset Has UK supply been adequate?

DD, Axa
Because of the increased volatility in markets, many investors have been risk-averse in their decision-making. UK pension funds have continued to do liability-driven investing on a scale that has, at times, meant that the total supply from government and non-government issuers has been inadequate.

JG, Standard Life A lot of companies that you might think were natural issuers of inflation haven’t issued. There are a couple of Tesco bonds, but they’re very small. The retail sector in particular remains a largely untapped source of supply.

MR, Dresdner Kleinwort
The corporate issuance we saw at the beginning of 2007 and end of 2006 was through negative basis trades. Banks were purchasing the bond, asset swapping it and buying monoline protection to transform it into an asset with a significant return over Libor. Through this process, those banks were able to over-bid the traditional real money accounts by as much as 5bp to 10bp yield. A lot of PFI issuances were as well bought as negative basis trades. You have to say it was the perfect opportunity. On one hand, the very long end of the real yield curve was extremely inverted, which was appealing to issuers. On the other hand, the monoline spreads were trading at very tight levels, which was helping synthetic buyers, but with that gone, the first half of 2008 will be difficult.

FM, Network Rail As Matthieu says, corporate issuance has almost all been done through the asset swap market, either directly or through quasi-public deals that are bought by the banks and monoline wrapped. With the monolines in trouble and the asset-swappers balance sheet constrained, corporate issuance in any size is likely to become very much more difficult. Will investors have an appetite for unwrapped, long-dated inflation-linked bonds? Or, to put it another way, will they look to allocate some of their risk budget to long duration, inflation-linked corporate issuance, whether it’s Tesco or it’s a utility, rather than more conventional issuance or other products?

Consequences of the crunch

PW, Western Asset What consequences has the credit crunch had?

Through the summer, the nominal markets reacted strongly and the inflation markets were stable, not only looking at break-evens. As we saw with the development of the options market, there was a divergence between the behaviour of inflation options volatility relative to interest-rate option volatility. Nominal market vol, particularly of gamma structures, was at record highs through the summer, while inflation vol was edging down. For the first time, there was a market, rather than banks simply selling volatility embedded in structures. So it had a level to bed down to find its starting point, and since then it’s tracked.

Nevertheless, through the summer you saw inflation and interest rate vol moving in opposite directions. Although corporate issuance, particularly swaps through the negative basis route, provides derivatives supply for inflation desks, it’s not the key source of LPI flows — PFI transactions are. Many pension liabilities are linked to 05-collared inflation. Through the course of this year and last, the bulk of that came through property-related transactions, sale and leaseback deals, stemming from property leases being linked to RPI and collared 05. If lending business is set back as much as the signs imply, it’s the supply of those transactions that’s going to hit LPI. As a function of break-evens moving higher, the 05-collar basis widens and that’s why we’re back at minus 9bp. One would expect it to be historically wide at these break-evens.

The cost of monoline wraps being infeasible for the negative basis transactions will affect that too. A monoline wrap serves a purpose, but there’s a finite number of monolines and people were at their limit of exposure anyway.

PW, Western Asset How has the credit crunch impacted investors?

JG, Standard Life
We’ve had, in many ways, a classic reaction to the end of a long-term bull market: a blowout of credit spreads; a re-establishment of more logical risk premia. That affects inflation markets as much as conventional ones. The lack of monoline-wrapped supply is going to cause further problems. Because it’s so illiquid in corporate inflation, there was little opportunity to reduce credit exposure before the blowout in spreads. A lot of institutional investors still have more credit risk than is healthy or appropriate. The lack of liquidity in both conventional and inflation-linked markets has meant it’s impossible to wash those positions out of the system and, until we get more capitulation, I don’t see markets going back to normality.

DD, Axa Many investors will look to be more risk-averse. In the corporate inflation sector investors would like to diversify from monoline insurers and utilities issuance but this will be difficult. The growth of esoteric instruments may well slow down. Not all our investors are willing to invest in inflation-linked swaps, for example.

PW, Western Asset How has the credit crunch affected inflationary markets in Europe?

GFP, Eurizon Capital
Some widening of the bid-offer spread in the swap market occurred. When capital is scarce and risk aversion increases, you find a widening of the spread between the fair value of the inflation and what you receive from the counterparty. It depends also on the term structure of the CDS spread of the counterparties. The credit spreads on EU non-core government bonds tend to be split between the real yield and the inflation the payer is going to ask. The widening of the asset swap between Euribor and European government bonds has a certain impact on the inflation implied in the inflation swap quotes.

PW, Western Asset Have issuers noticed the credit crunch showing up in terms of bid-offer spreads? Are banks suggesting opportunities?

FM, Network Rail
There’s been a difference in the way it has affected conventional and inflation issuance, with spreads on our inflation-linked issues holding pretty close to pre-credit crunch levels. That’s been less true for agencies on the conventional side. We plan to issue a further £2 billion to £4 billion in inflation this year, the majority through taps of our existing benchmarks, and we don’t expect a significant widening in spreads.

MC, Italian Treasury There has been more preference for linkers, probably because of the protection against fear of inflation.

MR, Dresdner Kleinwort
There is still liquidity in the eurozone. On the bond side, nominal bonds have been quoted wider on electronic platforms because of very volatile inter-country credit spreads, but break-evens have still been quoted remarkably tight. This is reflected by the very low implied volatility in the EUR HICPxt inflation cap/floor market. So we can say that the index-linked bond market has been relatively unaffected by the credit crisis relative to the nominal market despite the extra break-even component. The bid-offer spreads are slightly wider on the inflation derivatives side but globally the market is still attractive for investors.

Heightened awareness

PW, Western Asset Investors, how have you seen the development of liability-driven investment?

JG, Standard Life
There is a raised awareness of appropriateness of one’s assets and liabilities. That’s reflected in the liability-driven investment solutions available, and the asset mix of pension funds. Where are people’s equity holdings relative to their bond holdings? Where are inflation-linked holdings relative to other bond holdings? Those have been changing, which has taken UK break-evens to inflated levels. One of the biggest drivers for break-evens has been the level of the equity market. People putting on liability-driven investment solutions that involve coming out of risk assets such as equity and property into lower-risk assets often don’t particularly care where break-evens are. They care about the relative terms between selling equities and buying bonds, and with equities still at fairly elevated levels, those are still good. There’s a broad continuum of product, and it’s not just specific asset liability matching that’s driving the movement.

DD, Axa Some have suggested that we’ve had the peak years of liability-driven investment, with most defined benefit schemes now closed to new entrants. However, mortality continues to improve, so there will continue to be demand for long-dated investments to match liabilities. In addition investors are still trying to solve the problem of how to hedge the risk of increased mortality.

PW, Western Asset TFR is a new development in Italy. But how do you see the rest of Europe?

GFP, Eurizon Capital
There is a shift towards letting the saver suffer the burden of risk instead of the schemes. There have been some product design proposals that optimally mix defined contribution and defined benefit plan features. There have also been difficulties with appropriate asset-liability management practice in core Europe, excluding the Netherlands. I see more focus on the DC and DC-plus way of investing retirement savings, because asset managers and insurance companies are not as well developed in core Europe. Variable annuities products issued by insurance companies in core Europe could be an interesting market in the future. This could be one of the big product innovations.

MC, Italian Treasury In Germany there is space for increasing demand for inflation-linked product. In Italy, it depends on improvements in the way pension funds are planned, but in Germany cultural change is required and that will take time.

JG, Standard Life
Historically that’s common. When the TIPS market started in the US, the investor base didn’t pay it much attention, nor did the consultants. We’re seeing the same in Japan. Domestic sponsorship in the JGBI market is very poor. There comes a point, though, when it reaches critical mass, and we’re getting closer to that in Germany and Japan.

MC, Italian Treasury The difference in Europe is that the critical mass is not represented only by domestic issuances, because the euro market is large now.

PW, Western Asset
For investment banks, has liability-driven investment been a disappointment or better than expected?

Within the euro area, liability-driven investment-related business is increasing, with more of a domestic focus. People are looking for the liquidity and the depth of market that the eurozone provides, but when they get to risk management and liability matching, they seek to move into domestic indices. People looked to the euro index first because it was all that was available, and that’s where liquidity was. But little recent domestic business has been in its own right and mostly has been switches. The amounts are modest, but these accounts have held the euro index for some time, awaiting the development of the index that they want to hedge.

PW, Western Asset So if you try to match something out with relative precision, the degree to which it’s a precise match comes to the fore. The lack of precision in relation to the inflation indices is noticeable.

MR, Dresdner Kleinwort
Compared with the UK, demand is still lagging. The German index-linked market is still under development. About 15% of the 10-year went into Germany, with probably the same proportion in the five-year issued in 2007. For the moment the Bund ei 2016 is not trading as much in the secondary market as, let’s say, the BTP ei 2017. But with the credit volatility we experience these days and with nominal European bonds priced in spread over the German benchmarks, there is potential for the Obl ei 2013 and Bund ei 2016 to start to be used more and more as a reference in terms of real yield. Demand is growing in Germany but it’s a question of publicity and making people aware of the inflationary risk. They have to create the market, then demand will grow.

We see demand on German CPI on the derivative side, but it is too small for the country to start to issue this index. The only government that has gone the domestic route is France, and demand is still growing. There’s clear liability and enough demand with Livret A for that country to issue on its domestic index. On the derivatives side, we also see demand on local indices in Belgium and Spain.

CA, RBS The banks’ task is to match demand with supply. Whereas supply comes naturally in the UK via corporate issuance that can be swapped, one has to go looking for supply in Europe, and the sources lend themselves more naturally to domestic indices. Whether it’s a PFI-style structure or some property-related transaction, be it linked directly to the property or CPI-linked lease, it’s going to be in the domestic index rather than eurozone-wide. We’ve been searching for these sources of supply and we’re starting to see trickles of these domestic indices which are being converted into rate-style bond issues.

Headache for trustees

FM, Network Rail It’s complex for pension funds and for pension trustees. Take the Railways Pension Scheme, for instance, with around £20 billion of inflation-linked liabilities. The answer to our inflation exposure is not as simple as buying £20 billion of inflation-linked bonds or swaps, even if you could access them. A wholesale switch to inflation-linked bonds would significantly increase the actuarial deficit. A bigger deficit means higher contributions, which in the case of the RPS means higher member contributions as well. Add to this the added complications of an industry-wide scheme with 300 employers and you can see why pensions trustees take their time before executing liability-driven investment-style solutions. Trustees need to make sure they’re matching liabilities, but if they go too far, the pension scheme will close because it’s too expensive. It’s not straightforward.

PW, Western Asset Investment banks are wholesalers of all this risk, but not intended to be the end taker. We’ve seen more taking on of the risk within the wholesale environment, because they’ve been forced to wholesale the risk as an intermediary. Has the movement towards liability-driven investment forced a concentration of risk within the investment banking community? Can the banks cope?

CA, RBS It’s the role we put ourselves in and it’s our task in that we have access to supply, and we endeavour to seek demand. But in terms of the warehousing risk, it’s frustrating that liability-driven investment managers don’t have the mandate to be more creative. Given the focus on best execution and dealing as close to need as possible, it’s ironic that when I find some supply and am able to offer an above-market size at attractive levels, the response is: "Thanks for the information. I’ll get back to you when I’ve got something to do."

FM, Network Rail The market does not function as well as it should, but, because we know we have large supply coming and we’ve got a strong credit, we are in a better position than most. We are very happy to work with banks and investors to match demand with supply and, as a result, take some of the market-makers’ risk out of the equation. We can, for instance, use both pre-hedging and private placements to feed supply into the market in response to specific liability-driven investment demand. The result should, in time, be greater certainty of execution and less price leakage.

DD, Axa We’ve got a wide variety of clients. There are many reasons why they look to invest at different times. Much as we try to, that can’t necessarily exactly coincide with when there’s going to be a good supply in the market.

MC, Italian Treasury
We only accept private placement proposals if there’s obvious benefit in cost of funding. If they are maturities in our normal basket, we act only on an arbitrage basis. It’s also interesting to collect proposals from the market. In 2008 we will be able to offer a tool-kit to help match asset liabilities, because we have prepared a strip programme with inflation linkers. We have divided inflation linkers into the coupon, the principal nominal part and the inflation component of capital at risk.

GFP, Eurizon Capital That could help match properly, but the market lacks a proper hedge against this risk. Everything now is going on the banks’ books on the local indices and there is no natural exchange-traded hedge against which to match the other side of your book. The market is still in its infancy. There will be new European inflation futures contracts traded on the Eurex. That could be a good gauge of whether people want to create liquidity in the market. This could solve the problem but it will encounter difficulties because nobody wants to give up profits coming from private information, especially not investment banks.

MR, Dresdner Kleinwort The Agence France Trésor decided last year to make its inflation-linked bonds eligible to stripping operations but we haven’t seen much demand for it so far.

PW, Western Asset
And so to the question: "Does inflation matter?" It seems the product will grow if inflation is an issue, either because a lot of people have the risk so need to defease it, or because people are worried about it and want to defease it. But will inflation actually be a problem?

GFP, Eurizon Capital Ask retail people in Italy if inflation is a problem. The end user is well aware of the cost of gasoline at the pump. Having said that, the demand shock in oil that we have experienced since 2003 is mostly cyclical. As a symmetric parallel, only until the end of 2006 people used to believe equity volatility became structurally low. People have very short memories in finance. I don’t believe inflation is dead, but eventually there will be fewer monetary policy errors.

MC, Italian Treasury At the moment, emerging markets contribute more to deflation than inflation, but it’s moving in the opposite direction. The increase in oil and food prices is caused by the increased demand from emerging countries. In particular, the pressure on food prices has also increased by the effort to diversify energy sources. Biological fuel is an important element in increasing food inflation. I don’t know how long it will be reasonable to distinguish between traditional core inflation and headline inflation. We are more experienced than in the past in keeping inflation under control but it cannot be ignored.

More control

MR, Dresdner Kleinwort Short-term monetary policy is better, so there will be more control than in the past.

PW, Western Asset
According to the economist profession, inflation is expected to be high for the first half of this year in the US, Europe and the UK, and to abate in the second half. We’re going to see the short-term effects of previous energy shocks, followed by the absence of strong growth and maybe even concerns about weaker growth putting pressure on inflation rates. Into next year most forecasts were below central banks’ targets. A corollary of this is that the credit crunch will affect growth, which will give rise to a more benign environment on the inflation side.

MR, Dresdner Kleinwort The common view is that there will be a recession in the US, coming to the UK, and then to Europe. In the UK, I think it is overdone to see UK base rate down to 4% by Q1 2009. I don’t think the UK housing market is as fragile as in the US or that the UK will follow the US in recession.

JG, Standard Life Inflation is not a homogenous phenomenon. We’ve currently got mainly cost-push inflation, with food and fuel prices rising. It’s not demand-pull inflation in the textbook sense. If we get the appropriate monetary policy response, possibly even fiscal policy response, to push economies ahead over the year-to-18-month horizon, emerging economies will continue to grow, and demand will grow from them. Then you might get demand-pull inflation. The cost-push inflation might increase demand for inflation-linked product in real yield terms, although not necessarily in break-even but if we’ve got demand-pull, one logical response would be to buy equities. Inflation-linked bonds are not the only inflation hedge, even if they are the safest. If the inflation is coming from stronger growth, this is not the asset class you want. You might want to receive the swap or buy break-evens, but you probably don’t want to buy the bonds.

CA, RBS As a market grows, demand and activity will build up. When inflation markets took off in 2003-04, that wasn’t as a result of particular inflation fears, or at a peak in inflation. Central banks had kept inflation on track. The fact that inflation activity might come as a response to inflation fears doesn’t hold. The introduction of new products and the ability to hedge inflation, not through index-linked government bonds, is going to see a pick-up. Inflationary fears may fuel index-linked business but it wouldn’t tail away if everyone thought inflation was under control. We have probably seen the peak prints in many indices. We may hover at these historically high levels but we probably won’t go higher in the short term, and I would expect things to come off a little. In the UK and Europe, we could see business fuelled by newer products and people embracing more complex products. Inflation has become its own asset class. In terms of the products offering, we’ve gone beyond inflation simply being that you can buy inflation swaps or index-linked bonds. Option and swaption markets are developing and we’re seeing genuine structured products and hybrids. We are beginning to offer the same suite of products as the interest rate market.

The flip side

FM, Network Rail We look at this very differently. We’re the flip side of liability-driven investment. We’re asset-driven issuers. If we believed that inflation was back, in theory we ought to stop issuing our inflation bonds, and stick to conventional issuance. We don’t look at it that way. That’s not our business and since we’ve got a perfect inflation-related asset-base revenue stream, it’s smart for us to issue inflation. Secondly, the UK regulators assume that you are issuing inflation, because all revenues are set on a real basis. If you then don’t issue inflation, you find that you’re economically okay, but in cash terms underwater. So we look at it in a way that is independent of what inflation or the outlook might be.

DD, Axa I do wonder what the future role of inflation targets might be. We’ve had an explicit inflation target in the UK for 10 years and it’s proved very successful. If we get increased global inflation as a result of growing demand from emerging market factors, can that easily be solved by increasing purely UK interest rates? It will be interesting to see whether the inflation target regime continues to hold.

JG, Standard Life We need to find out if the MPC and the central banks have been good, or just lucky. This will only become clear once we see how they handle a turbulent period such as we have now.

GFP, Eurizon Capital
Everything is complicated by the fact that there are still emerging markets linked to the US dollar. If we lived in a perfect flexible exchange-rate regime, you could deal with inflation targets. But the peg makes it dangerous. At the moment we are very concentrated to follow emerging market developments, where short-term real rates are lower than real growth rate, especially in Asia and China. So, if the Fed lowers the Fed funds target rate to, say, 2%, in order to manage the real consequences of the burst of the real estate and easy credit bubble, we could not exclude suffering more inflation once two-thirds of the world has real short-term rates lower than real growth.

PW, Western Asset What does inflation mean to product development? Is there a stronger case for exchange-traded derivatives in inflation?

JG, Standard Life
If everybody would like to see it, why isn’t it there? I am sceptical about it coming in the near future. There’s not enough openness and liquidity in the market yet.

MR, Dresdner Kleinwort
Development in the inflation swap market always lags behind the interest rates swap market. Swapstream and CME plan to launch exchange-traded interest swap contracts this quarter. A lot of asset managers and hedge funds are interested. Because swaps will be traded forward on IMM dates, positions resulting from in-and-out trading will be automatically netted and you will avoid the fixing risks that are a problem in traditional OTC swaps portfolios. Through the clearing system of CME, any counterparty risk is taken off.

Eventually we will see the development of such an exchange on inflation swaps, but only in a few years.

CA, RBS We’ve been slow to get going because the fixing risk hasn’t really been present.

MR, Dresdner Kleinwort
The market-making community wants more instruments to hedge fixing risk. The EUR HICPxt derivatives market really exploded in 2003 with a lot of five-year maturity inflation swaps which will fix this year. So the timing is right for Eurex to launch new euro inflation futures based on HICPxt whose liquidity will be ensured by a community of market makers.

PW, Western Asset So is market-making capacity fundamental to the development of these derivative markets?

MR, Dresdner Kleinwort
It’s more important in euro, because the swaps tend to be shorter.

GFP, Eurizon Capital
I would bet on the development of local indices, because they better match the issuer and the buyer needs, the retail people, the saver. In the past, we had to convince our investor base that buys structured products that the European CPI is similar to the Italian one. They don’t believe that Italian CPI could be lower than the European, because historically Italy has had higher inflation.

JG, Standard Life That sort of fragmentation into local indices will militate against getting exchange-traded derivatives going, because it will decrease the homogeneity of the market.

PW, Western Asset
How do you see the volatility and option markets developing?

A lot of the developments have been about understanding exposures, understanding risks. That doesn’t translate into "therefore I must hedge them and take them out altogether". That’s why people welcome the option capabilities the market can offer. It allows you to put in hedging without locking in absolute levels. Both from the investor and the issuer side, whether you’re pre-hedging an issue or hedging your real rate liability exposure, swaptions permit you to express a view within a range and buy downside protection. You either pay for this upfront in terms of option premium, or, better still, put on a real rate swaption collar, where you fund one side of the trade by selling the other. If you consider a pension fund’s liability, where they’re exposed to real rates falling, but will benefit from real rates rising, they may be prepared to give up some upside to purchase downside protection.

PW, Western Asset Is this an opportunity for issuers?

FM, Network Rail
We get a lot of requests. Will you issue liability-driven investment? Will you issue Australia inflation? Will you issue euro inflation? Our asset is retail price inflation and there’s a vibrant RPI market. The benefit wouldn’t justify the increased risk. We’d like to see the growth of a basis swap market between different inflations. If we want to issue euro it swaps back into floating, then it comes back into sterling and then back to inflation. That is costly and credit intensive.